The author is a Forbes contributor. The opinions expressed are those of the writer.

Loading ...

Loading ...

This story appears in the {{article.article.magazine.pretty_date}} issue of {{article.article.magazine.pubName}}. Subscribe

So by most accounts, the Facebook IPO is disappointing. Facebook’s stock ended its first day of trading a mere $0.23 above the deal price and today, Day 2, it has dropped more than 10% intraday. It was no accident it closed ever so slightly above the IPO price, but many investors don't fully understand what is going on behind the scenes of an IPO, how banks might be betting against them, and the problems that arise when a stock trades below its IPO price.

So first things first: The Facebook IPO is only disappointing from a deal perspective – it is too early to pass judgment on whether it is a disappointment as an investment. Many great investments don’t have the most auspicious beginnings, while others might jump 50% on the first day of trading, only to flame out later. In other words, don’t judge the stock on one day of trading. The next Google or Apple rarely comes with the hype that they are the next Google or Apple. Facebook’s lack of a first-day trading pop creates a host of headaches for the dealmakers, funds that were looking for a quick profit, and perhaps some people at Facebook.

FB went public at $38 and spent most of the day in the $40-$42 range. Then, in the afternoon, the shares were met with heavy selling. Why did the stock sell off? Though there's no way of knowing exactly why, it is fair to say that one key driver is quick profit-taking. If you are a mutual fund or hedge fund and had a million shares allocated to you in the deal, and could sell those for a quick $5 million profit, you might be smart to do so. The annualized return is staggering.

But why did FB shares close ever so slightly above the deal price on Day 1? Banks in IPOs often support deals, especially in the final trading hours, in order to keep them from closing below the IPO price. In my opinion, this is something the SEC should focus on, as it is an area that is ripe for improved transparency to protect investors. For investors, the most important questions about how FB might trade over the next few weeks might just be “How many shares collectively do the banks own of the deal right now?” and “Are the banks net long or net short FB today?”

Banks Might Be Betting Against You

Very few investors realize that when a company goes public, the banks taking them public are often making trades on their own behalf, including shorting the very stocks they are taking public. Investment banks can short the companies that they take public – and they usually do. In fact, banks can take naked short positions in the companies they are taking public. In addition, banks can also buy shares of the companies they are taking public. What some term “stabilizing the market” may actually be creating a false sense of security.

It is all clearly expressed in the Facebook registration document and in almost every IPO document: underwriters may engage in transactions like shorting the stock, creating naked short positions, and even being long the stock. Know that they are doing this not to intentionally hurt investors, but in the hopes of creating a more orderly market. It might have the unintended consequence of doing just the opposite.

That is, individual investors might see a stock that went public staying at it’s IPO price at $38 and think that it represents the true market of investors, when in fact it does not.

So let’s see what typically happens. A company goes public and the bank that is leading the offering sells 10 million shares. With most offerings, the underwriters allow for a 15% “Green Shoe” or an extra number of shares to be sold. So for this example, the bank would be selling 10 million share + 15% of 10 million, or a total of 11.5 million shares. So on day 1, the bank sells more shares than it actually has, and creates a short position. Later in the day or weeks, the bank will cover the short position by buying the 1.5 million shares in the open market. Any shareholders who had a quick profit and were selling their shares, would meet with some demand from the bank.

But what happens when the shares drop, as they did with Facebook? Initially the shares went up, and the banks sell more shares than they have – meeting the demand for shares by over-selling the shares, creating a short position for themselves. They create this short position, knowing they will have to buy shares later in the day or week. If the stock drops a little from its highs, the bank can even make a profit on the short trade. Yes, the bank might be selling to you at $43, only to make money later in the day when the stock drops to $38.23, effectively betting against the investor they are selling to.

But if the stock continues to fall, the bank is faced with another dilemma – they need to stabilize the market and they start buying the shares. But how many shares can they buy? Do they cover their whole short position and then go long the stock? There is no proscribed limit. By buying the stock, the bank is doing its job of stabilizing the market, but it is also creating risk because then it owns a stock that can go down further. Like a finger in a dike, there is only so much a bank can do and is willing to do to stabilize a share price.